Abstract

China's push to make its own currency – the renminbi (RMB) – available
for use by non-residents was a catalyst for important reforms. Since the RMB
internationalisation policy began in 2009, not only is the RMB now in greater use
internationally, capital flows more freely across China's borders, the exchange rate
is more flexible and domestic interest rates are more market determined. In time, the
RMB could emerge as a widely used regional currency in Asia.

Introduction

A currency can be considered to be ‘international’ if it is used offshore for trade
and investment. There are strong natural drivers behind the international use of the RMB. China
is the world's largest trader, it is the second biggest economy and its securities markets
are among the largest in the world. Hence, as businesses become more comfortable using the RMB,
the currency is likely to become increasingly internationalised. Unlike other cases of currency
internationalisation in the 20th century, Chinese authorities began promoting the use of the RMB
outside its borders in 2009 while still maintaining extensive controls on capital flows and a
tightly regulated financial market (McCauley 2011a). The goal of RMB internationalisation has
been an important motivator for opening the capital account and advancing financial market
reforms. Indeed, greater use of the RMB internationally is likely to accompany capital account
opening and financial market reform in China.

A more open capital account in China could be transformative for financial flows globally,
including for Australia. Among other things, it will have an impact on the type of offshore
financial assets Chinese residents purchase. Most of China's offshore financial assets are
still held by the central bank, which invests in safe and liquid assets, such as government
bonds, in a range of advanced economies. However, as the capital account opens, private sector
entities in China will hold more foreign assets, and will probably hold different and more
diversified assets than the central bank does. Currently, China's holdings of offshore
portfolio assets (excluding the People's Bank of China (PBC)'s official reserve assets)
and associated outflows are much smaller than its Asian neighbours (Graph 1).[1]

Graph 1

But, if Chinese outflows as a share of its economy were equal to the average of its developed
Asian peers – around 3 per cent of GDP – they would have amounted to US$360 billion
last year. This is equivalent in value to the combined portfolio outflows of Germany, Japan, the
United Kingdom and France.[2]
However, the experience of other economies following capital account liberalisation suggests
that the process of greater integration is drawn out and, as a result, Chinese residents are
likely to increase their exposure to international portfolio assets gradually over a long period
of time (Graph 2).

Graph 2

A more open capital account may also be transformative for China's own financial markets.
Foreigners currently own about 2 per cent of the total amount outstanding in Chinese securities
markets, despite mainland Chinese securities accounting for around 10 per cent of the global
amount outstanding – making them the third largest capital market in the world (Graph 3).
This illustrates how under-represented Chinese securities are in global investors'
portfolios. Even for Chinese Government debt – which in the past has been more open to
foreign investment than corporate debt – the foreign ownership share is the lowest in the
Asian region (Graph 4). Increased foreign participation would create a more diverse investor
base in Chinese securities markets, which would potentially allow different types of credit risk
to be priced more accurately. It would also provide a catalyst for market development –
for example, in China's budding bond futures market. This would encourage yet more foreign
investment, resulting in a self-reinforcing feedback loop. However, a more open capital account
also has risks, such as more volatile funding flows.

Graph 3

Graph 4

Against this background, it is important to reflect on the developments to date in the
internationalisation of the RMB and consider the opportunities for the future. In doing so, this
article is organised into two parts. The first examines why the Chinese authorities sought to
have an internationalised currency while also maintaining extensive controls on capital flows
and a tightly regulated financial market. It also discusses the development of a pool of
offshore RMB as a tool to internationalise the RMB. It then examines trends in the international
use of the RMB, including in the Australian market. The second part is forward looking,
highlighting the RMB's natural fit as a regional currency in Asia. Some empirical evidence
is presented showing the emergence of an embryonic RMB currency bloc in the region, although the
evidence is far from definitive.

Why Internationalise the RMB?

In some ways, it is easy to appreciate why the authorities have sought an internationalised
currency – a policy push that began meaningfully in 2009.

Important symbolic benefits come from issuing a currency that is recognised internationally.
Such recognition provides an implicit ‘seal of approval’ for China's
markets, institutions and policies (Bernanke 2015).

Tangible benefits can also follow from issuing an international currency. It is often argued
that the US dollar's international role confers a so-called ‘exorbitant privilege’,
which is reflected in a lower-than-otherwise interest rate on US dollar financial assets.
This allows the United States to hold a net foreign liability position (with US residents
holding fewer offshore assets than foreign holdings of US assets), but have a net income
surplus (with US residents earning more on their total holdings of offshore assets than
foreigners earn on their holdings of US assets).[3]

Greater use of the RMB in trade reduces exchange rate risks and provides greater convenience
for Chinese exporters and importers whose other costs and revenues are mostly in local
currency terms.

Greater use of the RMB reduces the exposure of China's tradeable sector to sudden falls
in the global supply of US dollars. A reduction in US dollar liquidity during the global
financial crisis has been cited as a contributor to the substantial fall in Chinese exports
during that time (IMF 2009).

RMB internationalisation reduces borrowing costs for Chinese firms by increasing access to
offshore RMB funding markets. An offshore pool of RMB and the development of an offshore RMB
bond market – the so-called ‘dim sum’ market – have allowed mainland
Chinese firms to borrow offshore at rates that have often been lower than those available in
the onshore market (Graph 5). Borrowing offshore in local currency also reduces the exposure
of Chinese firms to exchange rate risks.

Graph 5

But, in other ways, the push to internationalise the RMB is unusual. Historically, the
widespread adoption of a currency for use by non-residents has depended more on fundamental
factors than policy initiatives. The historical record suggests three fundamentals in particular
seem to matter (Frankel 2012): economic size; confidence in the currency; and open and
dependable financial markets. In 2009, the Chinese authorities stepped up their efforts to
develop an offshore market for the local currency while still maintaining extensive controls on
capital flows and a tightly regulated financial market.

For this reason, some observers have also speculated that the push to internationalise the RMB
was tied to domestic development goals – namely, further opening of the capital account
and the liberalisation of the domestic financial system (Prasad (2017a, 2017b); Yu (2015);
Kroeber (2013) and Thornton (2012)). Indeed, some authors suggest that RMB internationalisation
has had parallels with the way the Chinese authorities were able to take advantage of China's
entry into the World Trade Organisation in 2001 as a vehicle for some domestic market reforms,
which otherwise could have been politically difficult to achieve (Gao 2016). The core of this
argument is that RMB internationalisation was used to accelerate China's capital account
opening, which would in turn build pressure to introduce further financial reforms.[4] According to this
view, a vehicle was needed for pushing ahead with further liberalisation of the financial system
because, by 2009, reform momentum in China had slowed. The liberalisation of the capital
account, domestic interest rates and the exchange rate were seen as essential for producing a
better allocation of capital and more sustainable growth in China.[5] But, despite being
on the formal policy agenda, these reforms had become politically difficult to progress in the
aftermath of the global financial crisis.

Once the capital account became more open, arbitrage required more flexibility in setting
deposit interest rates, as well as increasing the benefits of exchange rate flexibility. These
reforms did not necessarily have to be carefully sequenced – prioritising interest rate
reform over capital account convertibility and currency flexibility. Instead, the PBC had argued
that they could occur at the same time ‘in a coordinated way’, consistent with the
historical experiences of other economies (PBC 2012).

The global prestige accorded by the RMB's possible inclusion in the International Monetary
Fund's (IMF) Special Drawing Right (SDR) basket – which is reviewed only every five
years – also created a timeline for reforms. This is because the IMF viewed certain
reforms as necessary before the RMB's inclusion in its currency basket. This important
symbolic recognition came in late 2015, with the decision becoming effective in 2016.

The Reform Journey

The key component of China's initial efforts to internationalise the RMB was the
establishment of a pool of offshore RMB in Hong Kong. Not only was this important for the role
of the RMB, it was perhaps important as a catalyst for broader market reform.

The offshore pool of RMB

To establish the initial pool of offshore RMB in Hong Kong, two early reforms were critical.
First, in 2009 the PBC launched a pilot scheme (completed in 2010) that allowed selected Chinese
importers to pay for their imports in RMB using banks in Hong Kong, thereby carving out a
channel for RMB to flow out of China. Banks in Hong Kong were then permitted to open direct
correspondent accounts with mainland banks allowing these funds to flow back to the mainland.

As a result, the offshore pool of RMB increased rapidly over 2010 to 2015, driven by RMB trade
settlements.

RMB recycling and capital account opening

The establishment of this offshore pool of RMB was indeed effective in applying pressure to
further open China's capital account. Channels were opened to make it easier for offshore
Chinese banks looking to transfer their RMB deposits back to their domestic branches (Cockerell
and Shoory 2012). The authorities also built connections between the onshore and offshore RMB
markets through various pilot schemes that permitted lending between Hong Kong and the mainland
and vice versa. Bond proceeds from issuance of dim sum bonds were also permitted to be
repatriated back to the mainland with approval from the PBC. As a result, total banking-related
claims on China increased significantly. As these claims were related to the recycling of
offshore RMB deposits back to the mainland as loans (HKMA 2014), they tended to move closely
with trends in the offshore pool of RMB (Graph 6).

Graph 6

The authorities also opened up a number of new channels for foreigners looking to invest their
offshore RMB deposits in Chinese financial markets. These included the RMB Qualified Foreign
Institutional Investor program and direct access to the onshore bond market for selected foreign
investors. Schemes were also put in place to allow RMB outflows, including the RMB Qualified
Direct Institutional Investor Program. A number of two-way investment schemes were also
initiated, such as the stock connect programs (and later the bond connect program) linking Hong
Kong and mainland markets.

Rate reform

Hand in hand with these reforms, domestic interest rates were gradually liberalised. The freer
movement of RMB across borders posed competitive challenges to both benchmark lending and
deposit rates. This added impetus to local financial market developments that were pushing in
the direction of freeing up interest rates. For example, the development of saving instruments
that offered higher returns than traditional bank deposits – such as Wealth Management
Products – had become a popular way of getting around deposit rate ceilings. The
authorities also allowed banks to issue negotiable certificates of deposit, which had prices
that were market determined. An increase in shadow bank lending was also enabling the banks to
bypass formal lending restrictions.

To allow banks more scope to compete on lending rates, the bank lending rate floor was removed
in mid 2013. And to add flexibility to the controlled deposit ceiling, the authorities gradually
eased the cap on deposit rates. By late 2015, the cap was removed entirely, freeing up interest
rates on both loans and bank deposits.

The exchange rate was also slowly liberalised. In early 2012, the RMB's trading band against
the US dollar was widened from ±½ per cent to ±1 per cent and then to
±2 per cent in early 2014 (Graph 7). In August 2015, the PBC also increased the
transparency of the RMB's daily fixing rate around which the RMB can trade within the
±2 per cent band.

Graph 7

Trends in RMB Usage

Looking back, the RMB has made considerable progress towards becoming an international currency
over the past decade. A move further towards being a truly global currency would be supported by
an open capital account, with scope for the currency to be used in a way that is commensurate
with China's size in the global economy. The RMB accounts for about 2 per cent of global
foreign exchange (FX) turnover; 1½ per cent of global payments; 1¼ per cent of
global official sector FX reserves; and a negligible amount of international debt securities
outstanding (Graph 8).[6]
In contrast, China accounts for almost 20 per cent of global output and over 10 per cent of
global trade. Important in this respect is that developments in RMB usage have been driven not
only by longer-term ‘structural factors’, but also more cyclical ‘speculative
factors’.

Graph 8

Structural factors

Since the decision to allow RMB trade settlements in 2009, Chinese firms have naturally sought
to invoice more of their trade in RMB. In the presence of capital controls in China, the
establishment of offshore RMB ‘centres’ have made it easier for such transactions to
take place.[7]
Invoicing trade in local currency terms has enabled Chinese firms to better manage their
exchange rate risks. There is also a strong case for foreign firms to trade in RMB. Private
sector estimates suggest that Chinese importers have added as much as 5 per cent to their
foreign currency invoices to hedge against unfavourable exchange rate movements (Eichengreen,
Walsh and Weir 2014). By invoicing in RMB, international firms are also able to improve trading
relationships and access new trading opportunities.

For Australia, these structural factors have led to a steady increase in the share of our
merchandise trade invoiced in RMB, though from a low base (Graph 9). Around 2.5 per
cent ($1.5 billion) of our merchandise imports from China are invoiced in RMB and around 0.5 per
cent ($0.6 billion) of our exports. The local pool of RMB deposits is broadly consistent with
these numbers, fluctuating between $4–8 billion.

Graph 9

Speculative factors

But globally, changes in the stock of RMB offshore – most of which is held in Hong Kong
– has, in large part, been driven by ‘speculative factors’, in particular
expectations regarding the path of the RMB. The amount of global trade settled in RMB and
related changes in the stock of offshore RMB deposits have shown a strong association with the
value of the RMB against the US dollar (Graph 10). This pattern has been driven by Chinese firms'
willingness to adjust their use of the RMB to settle trade in line with their expectations for
the value of the RMB.

Graph 10

Over the period 2010 to 2015, Chinese firms' RMB payments for imports were larger than their
RMB receipts from exports. This led to a net outflow of RMB that ultimately supplied the
offshore market with RMB deposits, which increased from virtually zero in 2010 to over US$300
billion by 2015. These trade-related flows were driven by expectations that the RMB would
appreciate.

These expectations made the value of the RMB in the offshore (CNH) market worth more than in the
onshore (CNY) market. (Two markets exist for the RMB because the authorities have allowed the
offshore pool of RMB to be freely traded and delivered offshore in Hong Kong by all entities for
any purpose.) This naturally drove a net flow of RMB to where it was worth more in the offshore
market. These speculative flows resulted in a strong positive association between the offshore
premium (CNH premium over CNY) and the flow of RMB from onshore to offshore (Graph 11).

Graph 11

By contrast, over the period 2015 to 2017, Chinese firms' use of the RMB to settle import
payments declined, regardless of the level of the offshore premium. This occurred as
expectations for the path of the RMB shifted to a likely depreciation after the PBC increased
the role of the market in determining the value of the RMB in August 2015. As a result, the
value of the RMB in the freely traded offshore market became cheaper than its value in the
onshore market, stemming the flow of RMB offshore and naturally driving RMB back onshore. Over
this period, the stock of offshore RMB deposits halved in value, representing a significant
retracement in progress towards internationalising the RMB.

Shifting policy priorities

The authorities' focus on internationalisation of the RMB has not always been consistent, as
other policy priorities have, at times, taken precedence – for example, addressing
concerns about leverage within the financial system.

When the RMB was expected to depreciate, RMB internationalisation also became more difficult to
support as a policy. From mid 2014 to the end of 2016, the RMB depreciated by 10 per cent
against the US dollar, private capital outflows were around US$1 trillion and active PBC reserve
sales to support the value of the currency were around US$0.8 trillion (McCowage 2018). Of note,
in early 2016, the PBC intervened in the offshore market by buying RMB in the Hong Kong spot
foreign exchange market. This led to a large reduction in the supply of RMB in this market and
the overnight interest rate for interbank RMB loans in Hong Kong briefly spiked to almost 70 per
cent. The PBC also introduced measures that increased the costs and risks of holding RMB
offshore, including the introduction of a reserve requirement on offshore RMB deposits. To many,
this signalled the PBC's willingness to temporarily ‘sacrifice’ the offshore
market in order to manage expectations for the value of the RMB (Kroeber and Long, 2016).

More recently, however, as the value of the RMB began to appreciate over 2017, the value of
China's RMB trade settlements and the stock of RMB deposits have started to pick up again.
The Chinese authorities have also taken steps to replenish the offshore RMB market. These have
included removing the reserve requirement it had imposed on offshore RMB deposits and allowing
selected offshore banks to swap their onshore bonds for RMB cash in the mainland interbank
market (in so-called ‘repo’ transactions).

It is likely that the role of speculative factors in determining RMB usage patterns will recede
as the RMB-US dollar exchange rate becomes more market determined and so more volatile. Faced
with this reality, Chinese firms will be less inclined to adjust their RMB usage patterns in
line with their expectations for the path of the exchange rate. Instead, increased currency
volatility is likely to give rise to an increase in RMB usage for genuine risk management
purposes (Chinn and Ito 2015).

RMB Usage in the Asian Region

Looking to the future, Asia, and east Asia in particular, looms as a ‘natural habitat’
for the RMB to develop into a widely used international currency (Eichengreen and Lombardi
2017).

On the capital account, China has strong trade ties with its Asian neighbours and is a net
importer from the region (Graph 12).[8]
This means that the region is well placed to naturally accumulate RMB deposits.[9] At the same time,
China's Belt and Road Initiative (BRI) – a foreign policy and economic initiative
involving a program of infrastructure building throughout Asia, Africa, the Pacific and Europe
– is likely to become an important driver of RMB usage in Asia. Strong participation by
Chinese companies in the construction of these projects will increase demand for RMB trade
settlements, further promoting two-way RMB flows through the current account.

Graph 12

The BRI could also increase RMB financing flows to the region given the large value of the
program. Indeed, the Chinese authorities are promoting the use of the RMB for BRI project
financing (Global Times 2018, and Tan 2018).

Closer links to China mean that movements in the RMB should become more relevant for Asian
exchange rate markets. For example, the currencies of Asian economies in the same production
chain as China are likely to respond to global demand shocks in the same way as the RMB. The
currencies of large commodity exporters to China are also likely to respond to Chinese news in
the same way as the RMB. Closer links to China also create an incentive for those in the region
with managed exchange rates to stabilise the local currency against the RMB, which would help to
avoid a loss of competitiveness associated with exchange rate misalignments. These stronger ties
should, in turn, encourage central banks in the region to hold more foreign exchange reserves
denominated in RMB and provides context for the region's numerous RMB swap facilities with
the PBC.

An embryonic RMB bloc in Asia?

To explore whether an RMB bloc – a group of currencies that move closely with the RMB
– is already developing in the Asian region, we examine the co-movement of these economies'
exchange rates plus the Australian and New Zealand dollars (our sample currencies), with the
currencies in the IMF's SDR basket of major reserve currencies, including the RMB. A high
co-movement with any given reserve currency indicates that any news that affects that reserve
currency's relative price also affects the relative price of the currency in our sample in a
similar way. The measured co-movement could reflect a decision to manage the exchange rate of
the sample currency with reference to a basket containing the reserve currencies (for example,
in the case of Singapore) or be driven by the market (for example, in the case of Australia).
The empirical estimation establishes the ‘weights’ of the reserve currencies in
representing the changes in each sample currency. These weights reflect the relative co-movement
between the sample currency and the major reserve currencies; a reserve currency that has a
higher co-movement with the sample currency will have a higher weight. (For more details on the
procedure followed see Appendix A.)

The longer-term trend suggests the Asian monetary system is becoming bipolar, influenced by both
the US dollar and the RMB. The RMB has started to move more closely with Asian economies'
exchange rates. This is shown in Graph 13, which plots the estimated weights of the RMB in each
Asian currency's basket over two periods when the RMB was not fixed to the US dollar.[10]
Nevertheless, the US dollar is still by far the most important anchor currency for most
economies in the region. Any news that affects the relative price of the RMB now also affects
the relative price of the Australian and New Zealand dollars in a way that is commensurate with
the large weight of the RMB in their trade baskets. It is also important to note that the low
weight of the US dollar in the Australian and New Zealand baskets does not mean that movements
in the US are not relevant for Australia and New Zealand. Rather, it shows these currencies
react in a very similar way to the RMB in response to US-centric shocks.

Graph 13

While it appears that an embryonic RMB currency bloc is developing in Asia, the bloc is far from
stable. The size of the RMB bloc has declined almost uniformly over recent years, as shown in
Graph 14, which plots the daily evolution of the RMB's weight in each basket. These dynamics
are likely to have been driven by two factors.

Graph 14

First, trade is a key determinant of currency co-movements (Oomes and Meissner 2008). When
economies that have similar exchange rate patterns increase their trade with each other, the
co-movement of their currencies tends to increase. These ‘trade network externalities’
– which are especially relevant for the Asian region given their production links
(Berger-Thomson and Doyle 2013) – reflect that the trends in the size of the RMB bloc
relate to changes in the share of China's trade denominated in RMB (Graph 10).

Second, trends in the size of the RMB bloc in Asia also appear to reflect the way authorities
manage the exchange rate (McCauley and Shu 2018). For instance, since the RMB's effective
peg to the US dollar was dropped in 2010 there has been more two-way flexibility in the value of
the RMB, which coincided with an increase in the RMB's co-movement with Asian currencies. As
the Chinese authorities exercised more control over the exchange rate in 2017, there was marked
fall in co-movement of the RMB with other Asian currencies.

Conclusion

An important theme from this article is that the internationalisation of the RMB has to be
viewed in the broader context of China's financial and economic reforms. The first phase of
the policy push (spanning 2009 to 2015) served as a catalyst for important financial reforms in
China. These reforms have allowed market forces to play a more decisive role in the allocation
of resources in the economy, and further opened China up to the rest of the world.

If China continues to gradually open the capital account and move towards a more flexible
exchange rate, the second phase of internationalisation could see the RMB emerge as a widely
used regional currency in Asia. If this occurs, the accumulation of RMB deposits and the
recycling of these back into Chinese markets will significantly increase direct financial
linkages between the Asian region and China. As a small open economy with an already liberalised
capital account, Australia will also likely attract an increased volume of financial flows from
China, and a more internationalised RMB should see it feature somewhat more prominently in
Australian economic and financial transactions accordingly. It is reasonable to expect these
developments will generate a range of benefits from greater access to capital, as well as some
possible financial stability challenges if the volatility of capital flows increases, over the
medium term.

Appendix A Estimating Currency Co-movements with the RMB

The equation by Frankel and Wei (1994) is the starting point to estimate the co-movement
of the RMB and other major international currencies with Asian currencies, the
Australian dollar and New Zealand dollar:

Here,(x)denotes an individual Asian currency in terms of a common numeraire
currency(n). Daily data is used, denoted by time period(t). As such,Δ(xn)tcaptures the daily percentage change of a sample currency against the common
numeraire currency.

The weights on each reserve currency are given by the coefficient estimates(θUSD…θGBP). Like other studies, the Canadian dollar (CAD) is used as the numeraire as it
is a floating currency with no controls on capital flows. The results are robust to
using an alternatively floating currency – the Chilean peso – as the
numeraire.

The problem with just estimating Equation (1) is that the correlation between the change
in the US dollar and the RMB is very high, even outside of periods when China pursued a
US dollar peg. To overcome this, the two-step regression method of Kawai and Pontines
(2016) is used.

In the first step, movements in the RMB that are independent from movements in other
major reserve currencies are obtained as the residuals from the following regression:

Next, the residuals(w^t)are subtracted from both sides of Equation (3) and the condition that the
weights on the currencies on the right-hand side of Equation (3) add to one is imposed.
That is:(αUSD+αEUR+αJPY+αGBP+αRMB=1).

Estimation of this regression for each Asian currency yields the RMB weight as(αRMB=1−αUSD−αEUR−αJPY−αGBP). To produce Graph 14, rolling daily regressions for each economy over a
two-year window (520 days) are used.

It is important that all results for the weight of the RMB be interpreted as an upper bound.
This is because the methodology assumes that all coefficients on the right-hand side of
Equation (3) add to one. If this does not hold, any unexplained movements in reserve
currency baskets are attributed to the RMB.

Australia could be a large recipient of these portfolio flows. While of a different economic
nature, Australia has been an attractive destination for Chinese outbound direct investment
flows (McCowage 2018).
[2]

Some argue this benefit is not directly attributable to the US dollar's international role
(McCauley 2015).
[3]

These reforms had been on the PBC's formal policy agenda since the early 2000s and were
listed as priorities by the government in the 11th and 12th Five-Year Plans.
[5]

Caution should be adopted when interpreting data on the RMB's role as a payments currency.
These data double count some transactions and they capture bank-to-bank activity rather than
underlying commercial flows. For example, commercial transactions between China and the rest of
the world that are intermediated through Hong Kong would be recorded as two transactions.
[6]

These offshore centres – including that of Australia – were established through the
introduction of a number of initiatives, including official RMB swap facilities (of which there
are around 40 globally), RMB clearing banks, direct currency trading and RMB investment schemes
(see Hatzvi, Nixon and Wright (2014) for a discussion).
[7]

This excludes Hong Kong, as a large share of China's trade is exported to Hong Kong and then
re-exported without being transformed in the process (Day 2015).
[8]

This assumes that the propensity to use the RMB for exports and imports is about the same. This
is not necessarily the case. For example, China has a trade deficit with Australia, but a larger
amount of our imports from China are denominated in RMB compared to our exports. This is because
Australia's resource exports to China are mostly denominated in US dollars.
[9]

The RMB was fixed to the US dollar in 2008 in response to the financial crisis.
[10]